This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

September 23, 2013

Alternatives to Fixed Income Come in Many (Alt) Varieties

In this, the second of our two-part series on strategies for advisors and their clients to replace their current fixed-income exposure (see part one here), we’ll focus on what to look for in an alternative mutual fund or ETF and the use of scenario testing.

So we’re mostly in agreement that interest rates will head higher. Whether they come a lot sooner or a little bit later, these rising rates have the potential to destabilize asset allocation models. We can also agree that advisors, unlike their counterparts of years past, have options beyond quality and duration to help manage their way through the coming fixed income challenge.

As discussed in part one, the good news is that investments in categories like High Yield, Floating Rate Loans, Emerging Market Debt, and Dividend Paying Equities can help fill the fixed income space in an asset allocation model. The better news is, we believe there’s more.

Enter the Alts

Indeed, beyond what would be considered more ‘traditional’ approaches, today’s investment professionals have access to the rapidly-expanding alternative (or non-traditional) fixed-income space. Broadly speaking, these are fixed income strategies designed to provide just what asset allocators are, or will be, looking for: Uncorrelated returns and lower volatility.

And just how do these strategies perform this kind of magic in a rising interest market? The easy answer is these not-so-easy approaches rely on high active management discretion that is not restricted to any investment style. This space consists of managers who have the ability to buy bonds, decrease duration, short bonds, buy derivatives or go to cash if need be to protect capital. Many utilize leverage. These are classic go-anywhere approaches, in other words, and they are the epitome of short-term, dynamic trading strategies.

Figure 1: Alternative Bond and Hedging Strategies Overview

Well-run funds and strategies, including certain merger-arbitrage and market neutral offerings, can limit interest rate risk by maintaining shorter durations and add alpha through diversification across a broader opportunity set, all with relatively low correlation to bonds and equities. Moreover, these low volatility, low duration strategies can act as a portfolio stabilizer—the same role core bond allocations have played for the last thirty years—in a rising-rate environment.

It’s also important to note that alternative strategies, with their flexibility around trade structure and investment horizon, can still provide an attractive yield in the form of short-term capital gains. That’s not the same as a bond coupon—there’s no guarantee and returns will vary over time—but alternative strategies can produce compelling yields with less sensitivity to interest-rate volatility.

What to Look For in an Alternative Offering

Not too surprisingly, the same complexity that provides these strategies with such alpha opportunity also increases the due diligence requirements. Even more, most alternative fixed income strategies have very short track records and their selection requires developing confidence in the manager. Determining how a manager with broad flexibility has added value through active sector allocation across the fixed income spectrum is critical.

In an ideal world, multiple historical market inflection points can be evaluated in order to see what portfolio shifts the manager made in order to add value. But since most of these funds have very limited track records, it’s important to look for other possible data. This can include separate accounts or limited partnerships the manager has been running with the same mandate, other similar funds the manager has run or it may simply be simulated back tests. Ultimately, it’s important to develop confidence that the manager is able to navigate shifting market environments.

Portfolio Construction Considerations

In the meantime, rates are so low now that any upward push could potentially have an outsized, negative impact on bond values. If bond values fall precipitously, the so-called ‘safe, non-volatile’ element of the traditional 60/40 portfolio could be neither secure nor stable. That’s why we believe that a portion of the investment grade bonds should be replaced with alternatives. But how big a portion?

As we argued in the first post on this topic, nothing can perfectly replace Fixed Income in an asset allocation model without some kind of interest rate risk. In other words, there is no ‘Magic Bullet.’ However, there is Modern Portfolio Theory and we can consider correlations and volatility when adding bond replacements. For starters, a 60% Equity/40% Fixed Income allocation might be updated to include 10% Fixed Income Alts in the bond space. Or 10% of Equities could be allocated to strategies that have higher volatility, like High Yield.

In any case, scenario testing like Historical Simulations and Monte Carlo Simulations should be implemented to better understand how the changes might affect the portfolios in different environments.

So to Conclude: What Is a Fixed Income Investor to Do?

If it’s true that interest rates are set to increase from their historically low levels, then the fixed income component that has served asset allocation models so well for the last three decades is at risk. In this environment, alternative strategies, with their ability to tactically change their fixed income exposure and actively hedge interest rates, can serve as a valuable complement to a fixed income allocation.

Beyond helping to improve returns, alts—like core bonds over history—may help to stabilize portfolio values during periods of heightened volatility. They also offer attractive, if varying, yields that are not as correlated with moves in interest rates. It will take effort to find a blend that best serves any asset allocation model, but finding the right combination promises to be well worth the effort.

---

Author’s disclaimer: For investment professional use only. Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned. Diversification does not guarantee a profit or guarantee protection against losses.